The limits to regulatory easing

The Bangladesh Bank's (BB) Financial Stability Assessment Report for July-September 2019 rightly observes that capital markets play a critical role in promoting financial stability. Nothing new, but indeed a timely reminder considering some recent initiatives whose unintended consequences could elevate the risk to financial stability.  The BB report appropriately cautions that since market capitalization and turnover in both bourses owe much to the banking sector, "stress on the banking sector may cause detrimental effect on the stock markets".  

Speaking of stress on the banking sector, a Fitch report has just highlighted two.  First, the decision to implement single digit lending rate is likely to subject the banking industry to continued surge in default loans by restraining their ability to adequately price risks amid poor lending practices and a bad loan recovery framework.  Second, massive loan rescheduling has helped banks to camouflage non-performing loans down to 9.2 percent, instead of allowing it to shoot up to 16.5 percent had they not rescheduled the NPLs.  

Fitch goes on to warn that the "the government's persistent intervention in the banking sector would raise the risk of another bank run in Bangladesh due to a loss in depositor confidence." Success in the attempt to cap lending rate at 9 percent could support a recovery in loan growth.  At the same time, it may renew buildup in default loans by inhibiting adequate pricing of risk, thus giving perverse incentives to less creditworthy borrowers. Expectations of default loan rescheduling elevates this risk further.  In such a landscape, one would expect tightening of prudential regulations. Not so, despite the efforts of some politicians, public-interest groups, commentators, and academics.  The regulator appears to be reticent to concerns about systemic risk. 

The latest manifestation is the BB circular on February 11 to prod banks to invest in the stock market.  Each bank can create a special fund worth Tk 200 crores for five years to expand their exposure to the stock market.  The banks can use their own funds or borrow from BB at 5 percent, instead of the existing 6 percent, for a 90-day period with a rollover extending to 5 years through repo or refinancing mechanism against treasury bills and bonds. The banks can invest the fund directly to build their own new portfolio (40 percent), new portfolio of their subsidiaries (20 percent), other bank or their subsidiaries (30 percent) and other merchant bank or brokerage houses (10 percent).  They also have the option to lend to share market intermediaries at 7 percent rate of interest.   

These investments will not be subject to the usual micro and macro-prudential regulations.  BB will not count the investments in the calculation of the banks' stock market exposure.  It will allow the valuation of these shares at cost in the banks' balance sheets, granting exemption from the "mark to market" rule (an accounting practice that involves recording the value of an asset to reflect its current market levels). The money lent to intermediaries will not be included in their Advance-Deposit Ratio which currently is not allowed to exceed 85 percent for the conventional scheduled banks and 90 percent for Islamic banks.    

The income of banks depends mainly on the amount of money they manage, which in turn depends largely on their portfolios' relative performance. To make their banks more attractive to investors, depositors and borrowers, bank managers tend to use every opportunity to camouflage risks by rescheduling loans, under-provisioning NPLs and not marking to market when prices of assets in their investment portfolio are down. But when all managers take such steps, they are mutually offsetting. No one benefits, yet the risk rises for all.  

The problem amplifies when the regulator incentivizes such behavior.  Ceiling on lending rate could force aggressive banks to increase lending volume without adequate due diligence on credit worthiness; reschedule and write off the bad loans to window dress their balance sheets and invest in shares to exploit the exemptions from prudential regulations. The more conservative banks may lose out if they do not follow suit, especially when the regulator wants them to. One might like to be rational even when everyone else is not. But then, as John Maynard Keynes observed long ago: "There is nothing so disastrous as a rational investment policy in an irrational world." 

An assessment of the soundness of banks becomes well-nigh impossible in such an ecosystem. Market participants will of course do their best to evaluate the soundness of banks before buying their debt or equity or placing large deposits there. However, since accounting statements are known to disguise the truth, investors will not rely on them, estimating the bank's condition as best they can. Changing how banks record the worth of their assets does not change the problem. Relevant stakeholders will make their own valuation assessments regardless of what the accounting rules allow the banks to claim. But not having the best possible statement of condition increases market uncertainty and the associated risk premiums about what the true condition is.  However, no single bank has the incentive to reveal the truth when it knows for sure the competitors will not do the same.  

This makes the financial system even more fragile. Powerful individuals benefit from the fragility and from the increasing laxity of regulations. Change will not come easily given the entrenched interests of those involved. Appropriate public understanding of the root cause of the problems beyond awareness of some of the obvious symptoms, such as high lending rates and many misconduct scandals, and of the true tradeoffs of different policy choices is essential. The financial sector is turning out to be a breeding ground of deep and broad problems in the nexus of corporate governance and political economy. 
One of the most important lessons of banking supervision of the last half century is that macro-prudential regulation is critical for putting individual and collective interests on the same boat. When policies undermining the traction of macro prudential regulations are put in place, some financial institution can prosper by responding to those policies.  Such prosperity is destined to be ephemeral as those left behind follow suit, thus eventually inducing everyone to forsake a cautious approach to risks. The public can easily fall prey to short-sighted promises of cheap credit. Turning a blind eye to systemic risk in banking is convenient. Policymakers who tolerate recklessness in banking rarely face political consequences. They wake up, as seen during the Global Financial Crisis in 2008/09, when the limits to regulatory easing unravel after the horse has bolted.

Time will tell whether the intended benefits from these policies will outweigh the costs of the unintended consequences.  Past experiences, our own as well as those of others, provide little assurance.  

The author is an economist.